When an alpha investor dominates a fund

Investors looking to increase their Asian private real estate exposure, but which lack the resources to take direct control positions, often eye indirect channels such as commingled funds.

But since 2013, fundraising for Asia-Pacific-focused funds has declined in terms of capital and the number of funds raised, according to PERE data. While 2013 saw 64 funds raise $19.2 billion, that dropped to 34 funds raising $10.5 billion in 2017.

Beyond diminishing choice for investors, another issue is materializing – funds being dominated by a single, powerful investor. The latest example came this week when Allianz Real Estate, the rapidly expanding real estate arm of the German insurance giant, secured a $175 million commitment in Shanghai-headquartered real estate investment manager KaiLong’s Greater China Real Estate Fund II. The vehicle is a closed-ended fund for value-add office investments in China and Hong Kong, for which the firm wants $500 million. The commitment captured 35 percent of the vehicle, considerably larger than the industry norm of 10 percent or less.

Allianz explained toPERE that by the time it underwrote the fund, KaiLong had already held a first close. The insurer wanted to back the firm’s strategy nonetheless, but a conflict of interest with two competing KaiLong vehicles ruled out a separate account. Dominating the fund’s subsequent closing was the route it pursued.

Allianz is not the first international heavyweight investor to do this. Abu Dhabi Investment Authority and Canada Pension Plan Investment Board have taken up similar dominant stakes in commingled funds, in India and in China. Both are following a brief encouraging strategic, high-controlling positions when making indirect investments. When separate accounts, joint ventures with operating partners or club vehicles are not an option, assuming major positions in commingled funds is another possibility.

But what does that mean for the rest of a fund’s capital? When institutional giants take up instrumental positions, the rights and benefits for other, smaller, less-able investors diminish. In the case of Allianz’s investment, the insurer gets an advisory board spot and first choice on co-investments. Allianz also receives favorable terms and fees as a cornerstone investor – privileges often reserved for first closers – and enough governance rights to veto certain investments, indirectly giving it control over the asset mix.

In cases like this, other limited partners need to consider the strategy of the big investor alongside that of the manager. In a sense, the commingled fund sees a dilution of its discretionary nature. In cases like this fund, where Allianz is a second-closing investor, it creates a particularly challenging prospect for first-close investors, which were supposed to be rewarded for showing faith, and subsequent investors, which now must underwrite two organizations, not just one.

Is this an Asia phenomenon? Instances like this are rarer in Western markets where most managers and investors are more observant of the 10 percent rule, even if a comparison between Eastern and Western funds is not strictly fair given the larger size of the latter. The average size of Asia-Pacific funds closed in 2017 was 53 percent and 29 percent smaller than those of Europe and North America respectively. However, that figure has been increasing since 2013, PERE data show, and the average fund size in Asia-Pacific exceeded the two other regions by end September 2018, suggesting it may become more of an issue.

Consultants point out that a smaller fund like KaiLong’s – market-specific with a niche focus – can better handle a dominant investor taking a 20-30 percent share, since its sharply defined strategy leaves little leeway for deviation. The issue is more prevalent when larger funds, around or above $1 billion, with a higher scope and execution pace, are joined by a cornerstone investor. As one consultant points out, it would be a challenge if a pan-Asia fund would have to maneuver according to the cornerstone investor’s cap share on one domestic market.

Investors should be alive to the implications of their investments being pinned to the strategies of two organizations and not just the one which marketed the fund in the first place. As fund sizes grow in Asia, however, it will be important to watch for larger, assertive institutional investors dominating commingled funds.